What is compounding?

What is compounding? It is the process of adding interest to interest on the principal sum of a deposit. You can look at it as reinvesting interest rather than paying it out. Also known as compound interest, it’s one of the easiest ways to build savings.

Key takeaways:

Compounding is a financial concept that involves earning returns not only on the initial investment but also on the accumulated interest or gains over time.
Compounding allows investments to grow exponentially as the earnings from each period are reinvested and generate additional returns.
The longer the investment period, the more significant the impact of compounding becomes.
Compounding is a key factor in wealth accumulation and can greatly enhance the growth of savings and investments.

Where have you heard about compounding?

Savings and cash ISAs are compounded when you leave money in a bank or building society account, so it's beneficial for savers. It's not so good if you're borrowing though as mortgages, personal loans and credit cards add compound interest to your debt.

What you need to know about compounding

Whether you have £100 or £100,000 to invest, you can take advantage of the magic of compounding.

The rate of compounding depends on how often the interest is calculated and paid. An account that pays interest on a monthly basis will grow faster than the same account calculating interest on a yearly basis.

The principle of compounding works in the stock market too. If you invest in stocks that pay dividends you can reinvest your dividend payments into shares of more stock rather than taking them as income. That way, those shares can grow too. The reinvestment can help your portfolio grow quicker than it otherwise would.